Equity Premium Predictability Over the Business Cycle

70 Pages Posted: 14 Jul 2021 Last revised: 9 Nov 2021

See all articles by Emanuel Moench

Emanuel Moench

Frankfurt School of Finance & Management

Tobias Stein

Deutsche Bundesbank

Multiple version iconThere are 2 versions of this paper

Date Written: July 2021

Abstract

The equity premium follows a pronounced v-shape pattern around the beginning of recessions. It sharply drops into negative territory just before business cycle peaks and then strongly recovers as the recession unfolds. Recessions are preceded by an inverted yield curve. Thus probit models using the term spread as predictor time the beginning of recessions well. We show that such model-implied recession probabilities strongly improve equity premium prediction out-of-sample. We document a structural break in the mean of the term spread in 1982. When correcting for this break, the forecast performance further strengthens, outperforming other recently proposed benchmark predictors.

Keywords: Business cycle, Probit Model, Recession predictability, return predictability, term spread

JEL Classification: C53, E32, E37, G11, G17

Suggested Citation

Moench, Emanuel and Stein, Tobias, Equity Premium Predictability Over the Business Cycle (July 2021). CEPR Discussion Paper No. DP16357, Available at SSRN: https://ssrn.com/abstract=3886847

Emanuel Moench (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Tobias Stein

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

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